Petaluma FX Partners, LLC v. Commissioner of Internal Revenue Service

United States Court of Appeals
FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued September 24, 2009 Decided January 12, 2010

No. 08-1356

PETALUMA FX PARTNERS, LLC AND RONALD SCOTT
VANDERBEEK, A PARTNER OTHER THAN THE TAX MATTERS
PARTNER,
APPELLANTS

v.

COMMISSIONER OF INTERNAL REVENUE SERVICE,
APPELLEE

Appeal from the United States Tax Court

Edward M. Robbins Jr. argued the cause and filed the briefs
for appellants.

Sheldon M. Kay, Thomas A. Cullinan, and Julie P. Bowling
were on the brief for amicus curiae AJF-1, LLC in support of
appellants.

Joan I. Oppenheimer, Attorney, U.S. Department of Justice,
argued the cause for appellee. With her on the brief were
Gilbert S. Rothenberg, Acting Deputy Assistant Attorney
General, and Richard Farber, Supervisory Attorney. Judith A.
Hagley, Attorney, entered an appearance.
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Before: SENTELLE, Chief Judge, and GRIFFITH and
KAVANAUGH, Circuit Judges.

Opinion for the Court filed by Chief Judge SENTELLE.

SENTELLE, Chief Judge: Petaluma FX Partners, LLC
appeals from the Tax Court’s decision that it had jurisdiction
over several partnership-level determinations and that valuation
misstatement penalties applied. Specifically, the Tax Court held
that it had jurisdiction to determine that Petaluma was a sham,
lacked economic substance, and should be disregarded for tax
purposes; that Petaluma’s partners had no outside basis in the
disregarded partnership; and that the gross valuation
misstatement penalty applied. Petaluma FX Partners, LLC v.
Comm’r, 131 T.C. 9, 2008 WL 4682543 (U.S. Tax Ct. Oct. 23,
2008). For the reasons explained below, we affirm the Tax
Court’s holding that it had jurisdiction to determine that
Petaluma was a sham and should be disregarded for tax
purposes, but reverse its holding that it had jurisdiction to
determine that Petaluma’s partners had no outside basis in the
partnership. In addition, we set aside the Tax Court’s holding
that it had jurisdiction to determine whether accuracy-related
penalties applied and that the valuation misstatement penalties
did apply in this case.

I. Background

A. Factual Background

This case involves a “Son of BOSS” tax shelter. Like many
of its kin, this tax shelter employs a series of transactions to
create artificial financial losses that are used to offset real
financial gains, thereby reducing tax liability. In 2000, the
Internal Revenue Service (“IRS”) identified Son of BOSS tax
shelters as abusive transactions. I.R.S. Notice 2000-44, 2000-2
 3

C.B. 255; see also Desmet v. Comm’r, 581 F.3d 297, 299 (6th
Cir. 2009). The facts of this case illustrate how this shelter
works. We rely primarily on the Tax Court’s description of the
facts, which is undisputed. Petaluma, 2008 WL 4682543, at
*1–3. Petaluma, a purported partnership, was formed on August
18, 2000. Its ostensible purpose was to engage in foreign
currency option trading. On October 10, 2000, Ronald Thomas
Vanderbeek and Ronald Scott Vanderbeek (collectively, “the
Vanderbeeks”) each contributed pairs of offsetting long and
short foreign currency options to become partners of Petaluma.
The Vanderbeeks increased their adjusted bases in Petaluma to
reflect the long options they contributed, but did not reduce
those bases to reflect Petaluma’s assumption of their short
options. On December 12, 2000, the Vanderbeeks withdrew
from Petaluma, which fully liquidated their interests in the
partnership by distributing cash and shares of Scient stock1 to
them. In keeping with 26 U.S.C. § 732(b), they took adjusted
bases in the distributed stock equivalent to their adjusted bases
in Petaluma immediately prior to the distribution. On December
26, 2000, the Vanderbeeks sold their Scient stock. Given their
inflated adjusted bases in the stock, these sales created
substantial short-term capital losses that the Vanderbeeks
subsequently claimed on their 2000 federal income tax returns.
For example, Ronald Thomas Vanderbeek sold his Scient stock
for $122,528 and claimed a short-term capital loss of
$17,776,360, which conveniently offset $14,472,420 in long-
term capital gains. Likewise, Ronald Scott Vanderbeek sold his
Scient stock for $39,410 and claimed a resulting short-term
capital loss of $7,631,542, thereby offsetting long-term capital
gains of $6,191,778.

1
The stock is not further identified in the parties’ submissions.
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B. Statutory Background

Although partnerships do not pay federal income taxes, they
must file annual informational returns reporting income, loss,
deductions, and credits. 26 U.S.C. §§ 701, 6031(a); Treas. Reg.
§ 301.6231(a)(3)-1(a)(1)(i). The partners are then responsible
for reporting their distributive shares of the partnership’s income
or loss on their individual federal income tax returns. 26 U.S.C.
§§ 701–702, 704. Congress established the current framework
for adjudicating partnership-related tax matters in the Tax
Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), Pub.
L. No. 97-248, § 402, 96 Stat. 324, 648-67 (codified as amended
at 26 U.S.C. §§ 6221–6232). Prior to TEFRA, all partnership
items were determined at the individual taxpayer level, which
often required duplicative proceedings for different partners and
sometimes resulted in inconsistent treatment of partnership
items from partner to partner. Under TEFRA, partnership items
are now determined in unified partnership-level audit and
judicial proceedings. 26 U.S.C. § 6221. When the IRS
disagrees with how a partnership return reports partnership
items, it may commence an administrative proceeding by issuing
a notice of final partnership administrative adjustment
(“FPAA”) to the partners. § 6223(a), (d). Once an FPAA is
mailed, the partnership’s tax matters partner has 90 days to file
a petition for readjustment of partnership items. § 6226(a). If
the tax matters partner does not file within that period, any other
partner who received the FPAA has an additional 60 days to file
a petition. § 6226(b)(1). Once a petition has been filed, the
reviewing court has jurisdiction to determine all partnership
items for the partnership taxable year addressed by the FPAA.
§ 6226(f).
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C. The FPAA and the Tax Court’s Decision

On April 2, 2001, Petaluma filed a Form 1065 partnership
return for its 2000 taxable year. The Commissioner issued an
FPAA to the Petaluma partners on July 28, 2005. The FPAA
disallowed all partnership items reported on Petaluma’s return,
reducing them from the amount Petaluma originally claimed to
zero. The FPAA also listed “Outside Partnership Basis,” which
was not originally reported on Petaluma’s partnership return,
and reduced its value from $24,943,505 to $0. In addition, it
included a section titled “EXHIBIT A - Explanation of Items,”
which determined that Petaluma’s existence as a partnership had
not been established, that it was formed solely for tax avoidance,
that it was a sham and lacked economic substance, and that it
should therefore be disregarded for tax purposes. The
Explanation also determined that Petaluma’s partners “have not
established adjusted bases in their respective partnership
interests in an amount greater than zero.” Finally, the
Explanation determined that various accuracy-related penalties
set forth in 26 U.S.C. § 6662(a) applied to all underpayments of
tax attributable to these adjustments. On December 30, 2005,
Ronald Scott Vanderbeek, a Petaluma partner who was not the
tax matters partner, filed a petition for readjustment with the Tax
Court.

In the Tax Court, Petaluma and the Commissioner entered
a settlement of stipulated issues in which Petaluma conceded
that the reduction of the line items in its partnership return to
zero was appropriate. Petaluma retained just two
arguments—first, that the Tax Court lacked jurisdiction to
consider certain issues in the FPAA, and second, that the
valuation misstatement penalties did not apply. Both parties
moved for summary judgment, and the Tax Court granted
summary judgment for the Commissioner on October 23, 2008.
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In its opinion, the Tax Court first held that it had
jurisdiction to determine whether Petaluma should be
disregarded for tax purposes. It reasoned that “the determination
whether Petaluma is a sham, lacks economic substance, or
otherwise should be disregarded for tax purposes is a partnership
item over which we have jurisdiction.” Petaluma, 2008 WL
4682543, at *9. Second, it held that because Petaluma had been
disregarded for tax purposes, the court had jurisdiction to
determine that the partners’ outside bases in the partnership
were zero because “there can be no adjusted basis in a
disregarded partnership.” Id. at *10. Third, the court held that
it had jurisdiction over the accuracy-related penalties because
§ 6226(f) gave it jurisdiction to determine “the applicability of
any penalty, addition to tax, or additional amount which relates
to an adjustment to a partnership item.” Id. at *11–12 (quoting
26 U.S.C. § 6226(f)). Fourth, the court held that “the gross
valuation [misstatement] penalty applies when the adjusted basis
of property is reduced to zero because a transaction was
disregarded as a sham or lacking economic substance and the
taxpayer claims an adjusted basis in the property of a greater
amount.” Id. at *14. Petaluma timely appealed.

II. Analysis

A. Jurisdiction and Standard of Review

Petaluma filed a petition for readjustment of partnership
items with the Tax Court under 26 U.S.C. § 6226. The Tax
Court’s decisions concerning such petitions are generally
reviewed by the U.S. Court of Appeals for the circuit in which
the partnership’s principal place of business is located.
§ 7482(b)(1)(E). When a partnership has no principal place of
business, as is the case here, the Tax Court’s decision “may be
reviewed by the Court of Appeals for the District of Columbia.”
§ 7482(b)(1). We review the Tax Court’s decisions “in the same
 7

manner and to the same extent as decisions of the district courts
in civil actions tried without a jury.” § 7482(a)(1). Since the
facts of this case are undisputed, we review the questions of law
it presents de novo. Andantech L.L.C. v. Comm’r, 331 F.3d 972,
976 (D.C. Cir. 2003).

B. Disregarding the Partnership

Petaluma contends that the Tax Court erred in holding that
it had jurisdiction to determine that the partnership was a sham,
lacked economic substance, and should be disregarded for tax
purposes. Under TEFRA, a court considering a petition for
readjustment has “jurisdiction to determine all partnership items
of the partnership for the partnership taxable year to which the
notice of final partnership administrative adjustment relates, the
proper allocation of such items among the partners, and the
applicability of any penalty, addition to tax, or additional
amount which relates to an adjustment to a partnership item.”
26 U.S.C. § 6226(f). Petaluma argues that the Tax Court had no
jurisdiction to determine that it was a sham and lacked economic
purpose because that determination was not a “partnership item”
within the meaning of § 6226(f). We disagree.

(1) Section 6233

The jurisdiction of the Tax Court over this case is governed
by 26 U.S.C. § 6233. That section addresses instances in which
a partnership return is filed, but the purported partnership either
does not exist or is not actually a partnership. In those
situations, § 6233 mandates that TEFRA’s provisions still apply
“to the extent provided in regulations.” Id. The relevant
regulations state that “[a]ny final partnership administrative
adjustment or judicial determination . . . may include a
determination that the entity is not a partnership for such taxable
year.” Temp. Treas. Reg. § 301.6233-1T(a). Under the
 8

statutory authority of § 6233, this regulation explicitly
authorized the Tax Court to determine that Petuluma was not a
partnership for the 2000 taxable year.

(2) Partnership Items

The next question raised by Petaluma’s argument is whether
the sham determination was a partnership item. The Internal
Revenue Code states that “partnership item” means “any item
required to be taken into account for the partnership’s taxable
year under any provision of subtitle A to the extent regulations
prescribed by the Secretary provide that, for purposes of this
subtitle, such item is more appropriately determined at the
partnership level than at the partner level.” 26 U.S.C.
§ 6231(a)(3). Thus a partnership item must be (1) “required to
be taken into account . . . under any provision of subtitle A” and
(2) identified by regulation as “more appropriately determined
at the partnership level.” Id. We conclude that the
determination that Petaluma was not a valid partnership meets
both elements of this test.

(a) Required to Be Taken into Account Under
Subtitle A

For the validity of a partnership to be a partnership item, it
must be “required to be taken into account . . . under any
provision of subtitle A,” which is the subtitle concerning income
taxes. We have little difficulty concluding that application of
the income tax provisions of Subtitle A to the tax liability of a
taxpayer who receives income from a purported partnership
entails a determination of the validity of that partnership. As the
Eighth Circuit has stated, “When filling out individual tax
returns, the very process of calculating an outside basis,
reporting a sales price, and claiming a capital loss following a
partnership liquidation presupposes that the partnership was
 9

valid.” RJT Investments X v. Comm’r, 491 F.3d 732, 736 (8th
Cir. 2007). Thus the first requirement of the test is met.

(b) More Appropriately Determined at the
Partnership Level

In arguing that the second requirement is not met, Petaluma
urges that the term “item” should be interpreted narrowly,
arguing that it only includes accounting elements such as
income, deductions, credit, gain, loss, and basis. As Petaluma
concedes, however, the Code does not define “item.” Moreover,
Petaluma’s attempt to cabin the meaning of “partnership item”
ignores the statute’s plain language authorizing the Secretary to
promulgate regulations that flesh out the definition of that term.
§ 6231(a)(3). The regulations that fulfill that mandate give
examples of partnership items that include “[t]he partnership’s
method of accounting, taxable year, and inventory method.”
Treas. Reg. § 301.6231(a)(3)-1(b). These examples make clear
that the meaning of “partnership item” extends well beyond
technical accounting elements.

Furthermore, the regulations state that the definition of
partnership item includes “the legal and factual determinations
that underlie the determination of the amount, timing, and
characterization of items of income, credit, gain, loss, deduction,
etc.” Treas. Reg. § 301.6231(a)(3)-1(b). The determination that
a valid partnership exists is a sine qua non for determining the
amount and characterization of all other partnership items. For
example, determining whether there is a valid partnership
necessarily controls whether there can be partnership income,
partnership gain, partnership losses, and so forth. This
regulation establishes that the validity of a partnership is “more
appropriately determined at the partnership level,” thereby
meeting the second requirement of the partnership item test.
Thus the determination that a partnership is a sham and lacks
 10

economic substance is a partnership item because it is a legal
determination that underlies the amount and characterization of
other partnership items. RJT Investments X, 491 F.3d at 737–38;
Keener v. United States, 551 F.3d 1358, 1366 (Fed. Cir. 2009)
(stating that “the nature of a partnership’s transaction—and,
specifically, whether a partnership transaction is a ‘sham’—is a
partnership item”).

Logically, it makes perfect sense to determine whether a
partnership is a sham at the partnership level. A partnership
cannot be a sham with respect to one partner, but valid with
respect to another. In addition, this conclusion is unsurprising
given that this court has affirmed the Tax Court’s determinations
that a partnership should be disregarded for tax purposes on
several prior occasions. Andantech L.L.C. v. Comm’r, 331 F.3d
972, 980 (D.C. Cir. 2003); ASA Investerings P’ship v. Comm’r,
201 F.3d 505, 506 (D.C. Cir. 2000). Based on § 6233, its
implementing regulations, and the regulations elucidating the
meaning of “partnership item,” we hold that the determination
that Petaluma was a sham, lacked economic substance, and
should be disregarded for tax purposes is a partnership item.
Given the Tax Court’s jurisdiction under § 6226(f) to determine
all partnership items, we conclude that the Tax Court acted
within its jurisdiction when it determined that Petaluma was not
a valid partnership and should be disregarded for tax purposes.

C. Outside Basis

Petaluma also argues that the Tax Court erred in holding
that it had jurisdiction to determine that Petaluma’s partners had
no outside basis in the disregarded partnership. An “outside
basis” is the value assigned to a partner’s investment in his or
her partnership interest. See American Boat Co. v. United
States, 583 F.3d 471, 474 n.1 (7th Cir. 2009). Under § 6226(f),
a court reviewing a petition for readjustment of partnership
 11

items only has jurisdiction to determine “partnership items.”
Under TEFRA, every item that is not a partnership item is
considered a “nonpartnership item.” § 6231(a)(4). Items that
are affected by one or more partnership items are “affected
items.” § 6231(a)(5). Petaluma argues that outside basis is an
affected item, not a partnership item, and therefore the Tax
Court had no right to determine that its partners’ outside bases
were zero. We agree.

On appeal the Commissioner concedes that outside basis is
not a partnership item in this case. Instead, he asserts that
outside basis is an affected item whose elements are mainly or
entirely partnership items. He maintains that the Tax Court had
jurisdiction to state the “obvious conclusion” that a partner
cannot have any basis in a disregarded partnership. The
correctness of this conclusion is immaterial, however, for the
question is not whether the Tax Court’s determination was
correct, but whether the Tax Court had jurisdiction to make that
determination at all in this partnership-level proceeding.

Here, the partners’ outside bases are affected items, not
partnership items. Unlike partnership items, affected items are
determined not at the partnership level, but at the individual
partner level. Once the partnership items have been finalized,
the IRS may make a corresponding “computational adjustment”
to each partner’s tax liability. 26 U.S.C. § 6230(c)(1)(A)(ii);
§ 6231(a)(6). When a computational adjustment directly
increases a partner’s tax liability, the IRS can assess the tax and
the partner must bring a refund claim to challenge the
computation. § 6230(c)(1). When a computational adjustment’s
effect indirectly increases a partner’s tax liability and
necessitates partner-level determinations concerning affected
items, however, the IRS must issue a notice of deficiency, and
normal deficiency procedures apply. § 6230(a)(2)(A)(i); Desmet
v. Comm’r, 581 F.3d 297, 302 (6th Cir. 2009) (describing these
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two assessment procedures).

Under § 6226(f), the Tax Court had jurisdiction to
determine partnership items, but it did not have jurisdiction to
determine affected items. We have already rejected the Tax
Court’s conclusion that outside basis was a partnership item in
this case, and we likewise reject the Commissioner’s contention
that outside basis, although it is an affected item, could
nonetheless be determined in the partnership-level proceeding.
The fact that a determination seems obvious or easy does not
expand the court’s jurisdiction beyond what the statute provides.
In other words, it does not matter how low the fruit hangs when
one is forbidden to pick it. We hold that the Tax Court had no
jurisdiction to determine that Petaluma’s partners had no outside
basis in the disregarded partnership. Finally, we note that
nothing about the concept of outside basis indicates that it is
more appropriately determined at the partnership level. If
disregarding a partnership leads ineluctably to the conclusion
that its partners have no outside basis, that should be just as
obvious in partner-level proceedings as it is in partnership-level
proceedings. Moreover, with the invalidity of the partnership
conclusively established as a partnership-level determination,
there is little danger that outside basis will receive inconsistent
treatment at the individual partner level.

D. Penalties

Petaluma also challenges the Tax Court’s jurisdiction over
accuracy-related penalties. The FPAA determined that “the
accuracy-related penalty under Section 6662(a) of the Internal
Revenue Code applies to all underpayments of tax attributable
to adjustments of partnership items of Petaluma FX Partners,
LLC.” Petaluma argues that since the Tax Court lacked
jurisdiction to determine outside basis, it also lacks jurisdiction
to determine that penalties apply with respect to outside basis
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because those penalties do not relate to an adjustment to a
partnership item. We agree. As the Tax Court noted, penalties
were formerly determined at the partner level. Petaluma, 2008
WL 4682543, at *11; American Boat Co. v. United States, 583
F.3d 471, 478 (7th Cir. 2009). In the Taxpayer Relief Act of
1997, Pub. L. No. 105-34, § 1238, 111 Stat. 788, 1026, Congress
amended § 6221 and § 6226(f) so that penalties relating to
adjustments to partnership items would be determined at the
partnership level. American Boat Co., 583 F.3d at 478. Section
6221 now states that “the tax treatment of any partnership item
(and the applicability of any penalty, addition to tax, or
additional amount which relates to an adjustment to a
partnership item) shall be determined at the partnership level”
(emphasis added). Likewise, § 6226(f) now provides that a
court reviewing a petition for readjustment has “jurisdiction to
determine . . . the applicability of any penalty, addition to tax, or
additional amount which relates to an adjustment to a
partnership item” (emphasis added).

The Tax Court held that its determination that Petaluma
should be disregarded for tax purposes sufficed to give it
jurisdiction over accuracy-related penalties. Petaluma, 2008
WL 4682543, at *12. We disagree. True, the determination that
Petaluma should be disregarded for tax purposes is a partnership
item, but the outside bases of the partners are affected items to
be resolved at the partner level. Neither the Tax Court nor the
Commissioner on appeal have forwarded any basis for the
jurisdiction of the Tax Court over affected items in this
proceeding. As it is not clear from the opinion, the record, or
the arguments before this court that the penalties asserted by the
Commissioner and ordered by the Tax Court could have been
computed without partner-level proceedings to determine the
affected-items questions concerning outside bases, we are
unable to uphold the court’s determination of the penalty issues.
While it may be that some penalties could have been assessed
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without partner-level computations, we cannot affirm a decision
that has not yet been made. Therefore, we vacate the opinion of
the Tax Court on the penalties imposition and computation. It
may be that upon remand, a determination can be made for some
portion of the penalties, but neither party has briefed that
question before us.

III. Conclusion

For the reasons set forth above, the decision of the Tax
Court is affirmed in part and reversed in part. We affirm the
decision of the court that it had jurisdiction to determine the
sham nature of the partnership entity. We reverse the decision
of the Tax Court insofar as it asserted jurisdiction over the
outside-basis issues. We vacate and remand for further
proceedings the Tax Court’s decision on the penalties question.

So ordered.